Can You Pay Off Your Home Mortgage Early?

Mortgages can be paid off early, but sometimes at a price.

Homeowners in good financial condition who wish to ease the monthly burden of a mortgage may want to investigate early payment. Some mortgages, however, carry prepayment penalties. These penalties vary with the loan contract and, in most cases, gradually diminish as more years of payment are completed.

Significance

By law, mortgage contracts must state clearly the prepayment penalty attached to the loan. Lenders intending to sell their mortgages impose this penalty because prepayment, which ends the stream of interest payments, makes the loan less valuable to prospective institutional buyers.

Conditions

The prepayment penalty may be imposed if the house is sold and the balance paid off. It may also be imposed if the borrower negotiates a different loan to refinance the principal balance. If interest rates fall and the borrower seeks out another loan to refinance, however, the savings in interest payments may amount to more than the prepayment penalty.

Penalties

Prepayment penalties amount to a percentage of the outstanding balance, or an amount equal to a certain number of months of interest payments. Remember that interest payments are higher in the earlier years of the loan, and principal balances decline very slowly. The prepayment penalty declines as the mortgage ages. Nearly all prepayment penalties disappear by the fifth year of the mortgage.

Limited Prepayments

If you do not intend to pay off the mortgage entirely, remember that the mortgage contract may allow a limited amount of prepayments per year without penalty. A typical maximum amount is 20 percent of the outstanding balance. These prepayment penalties can be negotiated after making an application for a loan, not after the mortgage contract is signed.

Negotiation

Lenders may be willing to reduce the interest rate if the borrower accepts the prepayment penalty clause. This option is usually available to borrowers with good credit and who would easily qualify for the loan anyway. Subprime borrowers who must pay higher interest rates usually are required to accept a full (and high) prepayment penalty.

Prepayment Penalty Prevention

Discuss prepayment options as soon as you begin applying for a loan. At closing, read your mortgage contract carefully. Lenders may have inserted prepayment language into this document that you weren’t aware of, and you won’t see the full text of the contract until the closing.